From independence, freedom and truth

Economy

Oliver’s world and other tales

Fernando del Pino Calvo Sotelo

October 11, 2012

Einstein defined insanity as doing the same thing over and over again expecting different results. Europe’s behavior fits this definition perfectly. Let’s see why.

The world does not trust Europe and, in particular, does not trust the health of its ailing financial sector. In order to lift these clouds of doubt, the bureaucracy of the EU has done what it likes best: create yet another agency, which they called the European Banking Authority (EBA). They immediately put the new organism to work performing stress tests in order to find the recapitalization needs of the European banks in what euro-fundamentalists call worst-case scenarios and normal people call realistic assesments. In July 2011 the EBA made its premiere estimating a capital shortfall of just 2.5 billion euros, affecting eight entities. How weird. Only six months later, a second stress test increased the total amount fifty-fold to 115 billion euros (26 billion of them corresponding to Spanish banks and cajas), affecting 31 entities, after using a more credible capital ratio. Dexia, for instance, passed this test with honors only to be nationalized by the governments of France and Belgium ninety days later. Finally, in May 2012, the EU announced a rescue fund for Spanish banks of up to 100 billion, four times the estimate made five months earlier.

The EU politicians’ guidebook has a chapter entitled “How to Perform Stress Tests and Look Good”. It’s a simple recipe, understandable to the average euro-fundamentalist, with just two ingredients: soft assumptions and low Tier 1 Capital ratios. Thus, an economically futile yet politically correct result is guaranteed. Following this recipe, Spain, under the close supervision of the EU, has hired an “independent” consultancy firm to perform and “independent” and “final” audit on the Spanish financial sector. The result has been called Oliver Wyman’s Report.

In this report there are three stakeholders: first, Oliver Wyman itself which, according to the stringent disclaimer, has restricted its scope of action to the consolidation and presentation of the data supplied by third parties without checking their accuracy. Second, those data suppliers, including the Spanish government, several real estate appraisers, audit companies and the banks themselves. Lastly, and carefully controlling each step, there comes the real boss, called the Strategic Committee: the Spanish government, the EU and the IMF. Please allow me to call this committee the Commissar. Well, the Commissar has decided the assumptions which determine the results of the report. These assumptions, I’m afraid, seem too often to be an exercise of goal seeking, that is, predetermining the result first and choosing the right assumptions later. The base case is so rosy that it has already been overrun by events. The worst-case scenario, more realistic but by no means fitting my definition of worst, foresees a further drop in real estate prices inferior to that estimated by the prestigious Funcas foundation, by basing it on a simple return to the mean of the home price-to-gross income ratio, and also inferior to that suffered by countries with similar real estate bubbles, such as Ireland.

It seems that the data collection process has been both serious and rigorous, and is presented in an unusually straightforward way. However, all the advantages of such a laborious, detailed and potentially useful process end up tarnished by unrealistic scenarios, an incomplete risk evaluation and a surprising and totally arbitrary choice of minimum Tier 1 Capital ratio. The latter unfortunately resembles a coarsely made-up version of the final recapitalization numbers, those relentlessly repeated by the customary propaganda.

As a consequence of these weaknesses, the report has not had the warm reception and unanimous applause we desperately needed. Financial markets yawn, Moody’s says it falls short, the WSJ and the FT both show their “skepticism”, The Economist echoes analysts’ “doubts” and the Harvard Business Review publishes an article stating that, as a rule of thumb, Ireland’s example advocates adding a zero to any figure the Spanish government arrives at (an obvious exaggeration that shows our total loss of credibility). The only enthusiasts, of course, are the euro-fundamentalists, fixated by keeping the European farce alive a little bit longer. Ostrich-like attitudes, the standard EU policy approach of running away from reality, are explained by their fear that should the Spanish financial sector’s Big Hole be exposed, the broader European Huge Hole would also be evident, tearing all their beautiful political experiment apart.

Rumors about the “bad bank” seem to point to another flight from reality. Both the apparent lack of private investors, against initial expectations, and the long period of time estimated for its complete liquidation, lead to suspicion regarding the appropriateness of its asset valuation. One must insist to the point of exhaustion that using true market values is a must, as is shown the Nordic countries’ success in dealing with their own banking crises two decades ago. If the few healthy banks are obliged to become shareholders of the bad bank (I assume they would not do so voluntarily), that should not be considered the entrance of private investors, but a redistribution of toxic assets from the bankrupt part of the system to the minority which appears to remain robust. In my opinion, this is precisely the opposite course of action that common sense would suggest, which is to preserve the few healthy banks above water, ring-fencing the rotten part of the system to avoid the spread of the disease. There’s no need to save the whole system; instead, we should focus our efforts in ensuring that the solvency of five or six entities remain well beyond any reasonable doubt, and start the rebuilding of the sector from here.

There’s an old Spanish saying which advises coming clean, rather than having to make a thousand intervening excuses. Why do we keep doing the opposite? Let’s not waste another trust restoring opportunity. Following the very transparency they promise, I suggest the Government opens to public access the model used by Oliver Wyman’s report. Therefore, any analyst or simple citizen (those who will ultimately have to pay the bill should have some rights, I assume) will be able to freely enter their own subjective most probable scenarios and their favorite Tier 1 capital ratio (say, 9%). It seems it would help relieve some mistrust.

Spain can get ahead of this crisis, but to achieve this we need to have our own personality and dare to be different. What I mean is that we have to stop tackling this crisis in the European style. With its customary secrecies and dilatory tactics, the EU thinks it buys time; in reality, it is wasting time. It thinks it can delude the market; in reality it just fools itself. Denial, hiding, postponement: Europe is following the path of Japan, which twenty years later has not yet overcome its bubble, and the outcome will be the same. If Spain gets rid of its inferiority complex, it will have a historical opportunity to follow a different path. The path to truth and success.

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